For Immediate Release
Contact: Barbara Buell at 650 723-3157 or [email protected]
Market Reform Boosted Stock Returns in Emerging Markets
STANFORD GRADUATE SCHOOL OF BUSINESS -- The decade between 1984 and 1994 was an extravaganza for emerging markets. Governments from Venezuela to Malaysia threw open the doors to their stock markets for the first time. In 1984 there were only two emerging markets in which foreigners could legally hold equity stocks. By 1994 there were at least 20 such countries. Investment was fueled by more than 100 new investment opportunities from freshly created country mutual funds to American Depositary Receipts (ADRs), which allowed investors to trade foreign stocks on the big bourses in New York or London.
Since 1996, it has all nearly disintegrated in a flash of imprudent banking, ill-advised government intervention, and currency collapse. To better understand the mechanics of emerging market finance for the future, Stanford Business School economist Peter Henry has analyzed the effect of stock market liberalization on stock prices. Using data from the International Monetary Fund, the International Finance Corporation, and the Economist Intelligence Unit, Henry constructed a model that takes into account key macroeconomic reforms in 12 emerging market countries from 1984 to 1994. He discovered that, on average, a country's first market liberalization caused an average 38 percent increase in stock market value in real dollar terms. This increase in valuation implies an average 38 percent decrease in the cost of equity capital.
Henry's study also estimates the stock market effects of four other key economic reforms--macroeconomic stabilization (such as inflation controls), privatization of government-run industries, the removal of exchange controls, and trade liberalization. By including the effects of these reforms in his analysis, Henry believes he is able to provide more reliable estimates than previous studies. His model measures the stock price response to each of the four major reforms. For example, he found that trade reform, such as the lowering of tariffs on imported machinery, was the most significant, triggering a 16 percent rise in stock returns.
Even controlling for these four reforms, the valuation effect of the stock market liberalization itself was 29 percent. "The data suggest that the economic effects may also have been large," says Henry, who became deeply interested in the effects of stock market reform when he conducted a 1994 study for the Eastern Caribbean Central Bank, which was then considering development of a stock market in its group of small islands.
In a related study, Henry found that stock market liberalizations are followed by a surge in the growth rate of private investment. In a sample of 11 developing countries that opened their stock markets, 9 experienced significantly higher growth rates of physical investment such as factories and machinery in the first year after liberalization due to the availability of cheaper capital. In the second year after liberalizaton, 10 of the 11 countries experienced significantly higher growth rates. Henry is currently conducting research on how stock market liberalization affects specific industries.
The lesson to be learned from the recent turmoil in emerging markets is not that stock market liberalization is a bad thing. "It's that large capital market inflows that are not properly mediated by the banking system create problems," explains Henry, who is assistant professor of economics. "Outside investors had built in the expectation that these countries were progressing on other macroeconomic reforms when they liberalized their stock markets. If foreign investors find out that these reforms haven't materialized, then there can be large swings in asset values, which is what we are seeing now."
Naturally, Henry believes it is essential to consider the simultaneous economic, political, and social events that occur with the liberalization of emerging markets. He cites the dramatic rise of the Argentinean stock market in 1989. Stock market reform there was accompanied by internal as well as international events that had significant effects. In addition to opening its stock market to foreigners, Argentina introduced a sweeping government stabilization plan, embarked on IMF negotiations, and developed a free trade agreement. Elsewhere investors saw the overthrow of Marcos in the Philippines, privatizations in Malaysia, a debt reduction deal in Venezuela, and tariff reductions in Colombia. All these events bolstered the emerging stock markets at the time, says Henry.
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